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September 07, 2017

IRS Prevails on Controversial Captive Insurance Structure

As tax attorneys in Columbus, Ohio, we assist many individuals and businesses with tax examinations, tax audits, appeals, and litigation relating to civil tax matters at the federal, state, and local levels. As part of that work, we keep up on tax cases in the United States Tax Court that may impact our clients. One case that Nardone Limited has been following is: Avrahami v. Commissioner, 149 T.C. No. 7, which was decided on August 21, 2017. Avrahami was a closely-watched case because of the recent IRS enforcement activity in the Captive Insurance area. The IRS is concerned about the abuse of Captive Insurance entities by third-party promoters and taxpayers that: (i) sincerely fail to understand the ramifications of a third-party promoter’s advice, or more likely, (ii) taxpayers that are blinded by the so-called tax savings created by the Captive Insurance structure.

What are Captive Insurance Companies?

A pure Captive Insurance company is one that insures only the risks of companies related to it by ownership (the “Captive”). When the insured pay an insurance premium to the Captive, the insured receive a deduction for the amount actually paid. On the other hand, the Captive is exempt from taxation on premiums received, up to a certain ceiling. The exemption from taxation on the insurance premiums allow the Captive to build up a large surplus. The Captive is then taxed on its investment income only. This is a significant savings for the insured that paid the premiums and, directly or indirectly, own the Captive.

So, Where Is the Abuse?

Before we talk about the specific abuse, we must first discuss the concept of economic substance—generally and in layman’s terms. The idea is this: for a transaction to have economic substance, the decision to enter into the transaction must be motivated by a legitimate business purpose and not solely for the tax benefits involved (i.e., it must have a substantial non-tax purpose). This is where the abuse lies. The Captive Insurance promoters that tout themselves to be tax attorneys, tax CPAs, and insurance experts promote the tax benefits of forming a Captive for various business owners that are generating significant amounts of income and paying a significant amount of federal taxation. These business owners are usually looking for creative ways to avoid paying taxes. The promoters are relying on the fact that the overall structure promoted is complicated and that the taxpayers will either not understand it, and therefore not challenge it, or simply be blinded by the significant tax savings promoted. As one person has attempted to explain to our firm, if it is complicated and sounds sophisticated, then it must be true, it must be consistent with the law, and the individuals promoting it must be smart since we (i.e., the business owners) do not understand it. In fact, when someone questions the business owner, the business owner will ask, “Why would my tax attorney, tax CPA, or insurance advisor steer me wrong?” Well, they are potentially steering you wrong because of the significant benefits that the promoters receive for setting up the Captive structure.

How are the Captive Insurance Structures Promoted?

The promoters will talk about the form of the transaction and how the form is consistent with and satisfies federal law, both statutory and common law.  The promoters will persuade legitimate businesses, which are already fully insured by traditional unrelated third-party insurance companies, that the business is underinsured. The promoters will tell the businesses that they need environmental insurance, terrorism insurance, and other types of insurance, not typically covered by the businesses’ current policies. The promoters will then go out and have an actuarial firm come up with the necessary premiums to implement the types of insurances chosen by the business. The two main problems with this promotion is: (i) the insurance is either not a practical risk for that particular business, and therefore does not represent an insurance coverage that an ordinary and prudent person would purchase for their business, or (ii) the premiums are unreasonably high that no person, other than one that is trying to avoid paying taxes, would actually pay. So, what happens is that the insured is either buying insurance for the next “zombie apocalypse” that will never impact that particular business or the taxpayer is purchasing insurance that could traditionally be purchased by a staple insurance company for much less than the amount paid by the insured to the insurer. It just does not pass the smell test and violates all sensibilities—other than the fact that it is entered into for the primary benefit of tax avoidance.

Nardone Limited Comment: In the Avrahami case, the Tax Court chose not to discuss the taxpayer’s or promoters’ motivations for entering into the transaction. The Tax Court missed an opportunity to send a message and deter Captive promoters and taxpayers from entering into substantially similar transactions. In my humble opinion, however, just like hundreds around the country that have yet to be identified by the IRS, this case appears to involve individuals that disguised a transaction that did not have a legitimate non-tax business purpose, and did so, for the sole purpose of obtaining the significant tax benefits, which culminated in generating deductions and sheltering income from taxation on a tax-deferred basis. It is important to point out that the Tax Court did ultimately abate certain accuracy-related penalties, likely based upon reliance upon the taxpayers’ tax professionals.  Either way, until the IRS gets more aggressive and begins going after the promoters, this abuse will continue.  To say it another way, what is the difference between a taxpayer that enters into a sophisticated scheme to shelter money through a Captive with no legitimate business purpose, and an individual that intentionally fails to report his income altogether? In both instances, they are not paying taxes; one is just more complicated than the other and harder to uncover and enforce.

The Avrahami decision is attached here. As the reader of this blog, read it yourself and come to your own conclusion. But, we will leave you with this:

“You know, you can put lipstick on a pig, but it’s still a pig.”

Nardone Limited frequently represents individuals and businesses in federal, state, and local civil tax matters, including appeals. If you or your business have been contacted by the IRS or the Ohio Department of Taxation, or are struggling with tax liabilities, you should contact one of our tax attorneys today. We will thoroughly review your case to determine what options and alternatives are available to you.

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September 07, 2017

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